Time to revisit the concept of insider lending?

According to the statistics provided by the Finance Minister on January 22 in the parliament, directors of various banks borrowed about Tk 173, 231 crores from their own as well as other banks. Directors of 25 banks have borrowed Tk 1,615 crore from their banks, constituting 0.166 percent of the outstanding loans of the banks.  Bank directors borrowed Tk 171,616 crores from 55 other banks, constituting 11.21 percent of their total loans.

How much of this is insider lending?

Insider lending is defined under the Banking Companies Act as any loan facility or guarantee or security provided to a Director of a bank or to his relatives. It must be sanctioned by the Board of Directors of the bank and has to be specifically mentioned in the bank's balance sheet. The total amount of the loan facilities extendable to a Director or to his relatives should not exceed 50 percent of the paid-up value of the shares of that bank held in Director's own name without the consent of the Bangladesh Bank (BB). The credit terms have to be the same as commonly applicable to the outside borrowers. There is no specific regulation on directors of different banks borrowing from each other.

Strictly speaking, therefore, only the 0.166 percent part of loans to the directors counts as insider lending.  Since a Director borrowing from some other bank is an outsider to the other bank, such lending cannot be considered as lending to insider even though the borrowing Director, typically also an owner, is an insider to the banking system. The Director borrowing from his or her own bank is an inside insider whereas the Director borrowing from a bank other than his or her own is an insider in the system but outsider to all others except one's own bank.

Insider lending of any kind need not necessarily be bad in principle but has precipitated several systemic breakdowns in practice. It can work, but when it doesn't, disasters follow.

Insider lending can facilitate financial transactions by overcoming extreme informational asymmetries that often plague less developed economies. China is cited as a case in point. Many studies attribute much of the financing of China's spectacular economic rise to the creation of specialized financial companies by Chinese business groups in the mid-1980s. These finance companies collected and redistributed funds within the group and even obtained funds from state banks on behalf of member firms. The finance company substituted for more well-developed formal financial system.

Experience elsewhere show that conflicts of interest under insider lending encourage insiders to loot depositors. Related parties borrow at lower rates, are less likely to post collateral and more likely to default than unrelated ones. The Mexican banking system in the 1990s is a case in point. Banks were acquired by local families that already controlled industrial groups. Insider lending significantly undermined financial stability. Russia's experience is as horrifying. The structure of banking in Post-Soviet Russia has had the effect of making looting a dominant strategy for private banks. Insider fraud and other problems were evident in 61 percent of 286 bank failures in the US in 1990 and 1991.

These experiences suggest that the risk that related lending may lead to looting is great when banks are controlled by industrial firms and corporate as well as regulatory governance is weak.

The reason for restrictions on insider lending is to protect "other peoples' money" from insiders.
Any lending to insiders that is not restricted places a risk on customer deposits. The oversight role in the management of a commercial bank is placed on the Board of Directors. The board would ensure the safety of depositor funds. In essence, because the Board of Directors has insight within the bank, unlike other outsiders, the expectation is that they will raise red-flags if they appear and notify the regulator or ensure there are risk management mechanisms to deal with any potential fall-out.  However, when the Board is dominated by members of a single family whose tenure is 9 years long, what mechanism is there to prevent them from lending to Board members of another bank on the understanding that the latter will return the favor?

Why is the logic justifying restrictions on lending to insiders within a bank not applicable to lending to insiders within the banking system?

The majority of bank insiders may be honest and prudent individuals who fulfill their duties in good faith. Yet, participation in insider lending practices within the system is a significant reality in Bangladesh's banking industry as the latest data shows. Mind you, the financial statements submitted to the BB are prepared by the Directors of the banks where only lending to the "inside insiders" is disclosed. Even in such disclosures, directors can report insider loans in the customer loans. Additionally, they can place them in the Non-Performing Loan category and may later write them off.

Because excessive and unregulated insider loans can severely upset the financial security of a bank and possibly lead to its failure, strict limitations and regulation of insider credit extensions are put in place to ensure a safe bank. The regulations governing insider credit appear at first glance to restrict many facets of insider credit transactions. The assumption is as long as insiders are restricted from plundering their own depositors, the bank is safe. 

Does that guarantee the safety of the system as a whole? It is quite evident that insiders still possess the ability to obtain credit in an unregulated manner as long as it is from other banks. There is nothing preventing the Director of a bank from colluding with the Director of another to extend credit to each other. Also, Directors of private banks allegedly borrow from state-owned banks to meet the capital shortfall in their banks.

Regulations seem to overlook the relationships among key players in the financial system. The focus on individual banks ignores the complex relationships among the players that could lead to system-wide risks.  There is a need to hedge systemic defects in the system by focusing on the banking system as a whole and the multifaceted relationships among key players. The best hedge against the malignant effects of insider lending is to enhance the quality of board members by ensuring that only fit and proper persons are appointed while entrenching greater transparency and accountability. What is needed is better regulation and enforcement, not more regulation.

The author is an economist.